Pros and Cons of a China Revaluation

From time to time, political furor erupts over the exchange rate between the Chinese yuan and the U.S. dollar. Many people claim that an undervalued yuan makes Chinese goods unfairly inexpensive for U.S. consumers relative to competing products of U.S. companies. An undervalued yuan (also known as the renminbi) also crimps U.S. exports to China, the argument goes. But a higher yuan could make Chinese goods more expensive for U.S. consumers, resulting in higher inflation that erodes living standards in the U.S.

Of course, since China is one of the leading buyers of U.S. Treasuries and other investments, and since U.S. consumers have grown dependent on a supply of cheap Chinese-made goods (many of which aren't even made here anymore), the notion of pressuring China to allow the yuan to appreciate hasn't gotten much traction other than a lot of hot air. The issue does erupt as a hot button from time to time, though. And since this is an election year, the Obama administration may more aggressively prosecute a currency revaluation agenda, as also might Republican contenders for Congress or the presidency.

But what would a revaluation do, anyway? Would it help or would it hurt? In a recent research report, "The External Impact of China's Exchange Rate Policy: Evidence from Firm Level Data" by Barry Eichengreen and Hui Tong and published by the National Bureau of Economic Research, we learn that the share prices of some companies would respond favorably, while stocks of other companies would take a hit. Let's explore.

The research examined share prices of some 6,000 manufacturing firms in 44 countries on dates when China revalued its currency in 2005 and 2010. The study also looked at periods when the market perceived a change in exchange-rate policy, as determined by unusually large movements in the renminbi in the non-deliverable forwards markets. A revalued yuan can improve market sentiment (by calming concerns about trade sanctions and retaliation), thus boosting share prices of some companies. It also has more direct effects on trade and possibly on interest rates, as an appreciating yuan could conceivably send U.S. interest rates higher through diminished Chinese purchases of Treasuries.

What we see is that the share prices of some non-Chinese corporations rise in response to expectations of an appreciation of the renminbi, though not universally so. Exporters of finished goods to China, not surprisingly, see a large positive benefit. However, non-Chinese suppliers of parts and other inputs to Chinese companies do not see any benefit, on average. This may be because analysts expect that the Chinese assemblers of the finished goods may experience diminished sales, at the same time that the currency appreciation helps the margins of those exporters of parts and other inputs. The two effects offset each other for these firms.

Another observation is that the share prices of non-Chinese companies that compete with Chinese companies in their home markets -- as well as other markets around the globe -- benefit from a revaluation. This makes sense, as these companies will benefit from a decrease in competition from China. On the other hand, for companies that compete with Chinese companies that import many of their components (which then become cheaper from a revalued yuan), that effect dissipates.

There is, however, little evidence of similar benefits for firms competing with China in their home markets when those companies are involved in processing trade -- when those companies assemble goods with parts and inputs sourced from abroad and then resell the finished goods. Since some of those components may come from China (and then become more expensive), the positive and negative effects tend to offset each other.

There is another consideration, though: the effect, real or perceived, on the direction of interest rates if China shuns the purchase of U.S. Treasuries. When markets believe interest rates may rise as a result, those companies that depend on external financing (i.e., bond markets) see their share prices suffer from a currency revaluation. Of course, to the extent that many companies have ample cash and perhaps little need to borrow, this effect may be muted in the current environment. Still, it is a risk that policymakers face in addressing China's currency, not just in borrowing costs for the debt the U.S. government issues, but also in the interest rates of all corporate bonds and other debt whose rates are tied to Treasuries.

Since jobs are perhaps the issue of the 2012 political campaign for many candidates, it may be inevitable that China, which many Americans believe is a threat to their job security, becomes fodder for political rhetoric, with some politicians taking a hard stand. Conversely, some politicians may be wary of pressuring China too much, given the potential for retaliation. Others (doubtful, in my opinion) may actually consider empirical analysis on the economic and financial impacts of a currency revaluation and take a more pragmatic approach.

Whatever the political outcome, the economic and financial outcomes are quite mixed. There are no simple answers to this issue, and I do hope that such a complex subject does not become a mere campaign slogan.